Managing dollar weakness

What’s happened this week?

James: Hello, it's Friday the 26th of September. This week I think we should talk about currencies. We met a UK manager yesterday, one of the managers we actually use in our blend of UK managers within our Funds and our portfolios and they're actually pretty constructive on the UK market which is good to hear and they weren't too concerned about the budget, which is also good to hear. One of our parting comments at the end was really talking about currencies and is there more potential for sterling strength against US dollar for example and then other currency pairs as well? A comment they made actually was it's not so much that sterling has been strong this year, although it has been slightly strong, it really is more a case of dollar weakness and there could be more of that still to come. So I thought we'd have a look at really what's been going on with the dollar, with other currencies out there and then how it can impact portfolio and fund performance returns.

So the US dollar has been weak year to date, there's no doubt about it, if you look at major currencies around the world and there's a basket of about 16 currencies that are classed as majors on Bloomberg, there are some that have done, well in fact all of them have appreciated against the US dollar, between a handful of percent in the case of the New Zealand dollar, the Canadian dollar up to 13% for the euro and even 16% for the Brazilian real. And sterling's 6% or so return comes nestled in the middle.

What has caused this?

As with the move of any asset class, there's always lots of different reasons you can attribute to why it may go up or why it may go down. The big one when it comes to currencies I suppose is interest rate differentials and expectations for how they may change and what that really means is essentially the interest you could get on deposit or from the base rate if you like from one currency comparing it to the other and that should give you a relative feeling of the relative attractiveness between the two of those. It's not that simple necessarily if you have to also take into account inflation differentials and other bits and pieces too, but you know that's one of the reasons why perhaps the US dollar is weakening year to date. It is looking likely to continue down this sort of monetary easing path, interest rates coming down. Whereas in other areas, I mean even the UK perhaps, there's a prospect of a slower rate cutting path, arguably the same in Europe as well.

In the US there may be a degree of sort of risk aversion coming in, or people who have used the dollar as a sort of traditional safe haven, maybe looking to diversify away from that somewhat. An example of that may be Swiss francs looking fairly strong despite the fact they've been cutting their interest rate, that's a sort of classical safe haven. And of course, gold and indeed other precious metals have done pretty well year to date as well. Again, that could be reflecting some of that sort of diversion of capital away from a traditional sort of safe harbour like the US to other places to give people that want to keep their currency or their non-invested allocations safer and more diversified elsewhere. We've spoken before about concerns around the state of the US economy over the long run, and that's reflected really in the yields of the 30-year treasury drifting up. And also of course, with the slightly more assertive foreign policy let's say, of the US over the year to date period. It may be at the margin people feel less inclined to hold as many dollars and as many dollarized assets as they had in the past, which also might be creating a little bit of selling pressure there too.

What’s the impact for investors?

James [00:06:58] The main implication for investors is really I suppose, from the perspective of the Funds and the portfolios that we run, is a translation effect of these different foreign currency moves into the reporting currency of our Funds and portfolios, which generally speaking is sterling. And when we think about the impact or the translation effect of currency moves as it's called, really it's either a headwind or a tailwind. So if your base currency, if sterling is performing strongly and therefore gaining in value against other currencies, if you're getting returns in other currencies and you're having to translate them back into sterling, that's essentially a bit of a headwind. So if your overseas asset is giving you 10%, but sterling has appreciated by 5%, you know, the net outcome of that is you get a 5% return in sterling terms. The converse is also true of course; if sterling is weakening, you get a tailwind to your returns through translation effects. So again, if you're getting 10% from your overseas investment, sterling's weakened by 5% in sterling terms, that overseas return is now 15%. So that's really why it's important to be aware of currency moves. Now, on top of that, not only do they move, they create volatility because they don't necessarily move in a straight line, they move in sort of a spiky way. And then when we think about managing portfolios and Funds there, you see the volatility introduced by currencies doesn't necessarily impact the equity allocation too much, but it can really taint the returns profile of the fixed income exposure. So for two reasons; one is that volatility and also the magnitude of those moves on the currency side compared to the general magnitude of moves of fixed income, it is sort of proportionately greater than it would be on the equity side. We generally get over long run larger returns from equity. It's also more volatile. And so the overall impact of currency translation effects there is somewhat diminished from what it would be in terms of the fixed income allocation.

What have we done about it?

That's why when we think about managing currency risk in Funds and portfolios, we hedge out the currency risk in the fixed income allocations and we leave it open when it comes to the equity allocation. So we take that foreign currency headwind or tailwind, that translation effect for the overseas equity allocation that translates back into sterling and you get either a headwind or a tailwind from that. Whereas in fixed income, we want to really get the returns of the bonds, the essence of the asset class rather than the currency taint. And let me give you a flavour for what that looks like year to date. So Global Government Bond Index, I looked yesterday, in US dollar terms is up about 7% over the course of the year. So it's a global set of government bonds. Whatever they return in their local currency, you then get the translation effect on top, it pushes the returns to 7%. If you look at the same basket of bonds in their respective local currency, if you translate that into sterling, where sterling has been stronger over the course of the year, whereas the dollar has been weaker, that same basket of returns over the same time period year to date, moves down from 7% into dollars to actually being slightly negative, ever so slightly negative in sterling terms because of the relative returns of those currencies versus sterling compared to the US dollar. And then the hedged version. So, again, exactly the same set of bonds, but the currency risk is removed via currency hedging. Either you can hedge it into any of the currencies you like really, but both in terms of sterling hedged and dollar hedged, the returns in both of those instances is 2.9%. So the actual return of the asset class, the bond, is positive 2. 9%. That's a decent return. It's sort of in line with what you'd expect from Global Government Bonds over a year to date period. It's perfectly reasonable. And without the currency taint overall, it's neither plus 7, which it is in dollars, it's neither flat to slightly down, which would be in sterling, the actual return on a currency head basis, what you're getting from the essence of that asset class, the bonds themselves, is actually 2.9%.

That's it from me. Have a great weekend when you get there and we'll see you next time.